The CPI has gained an almost mythical stature among investors, who look for signs of inflation in the comprehensive monthly survey of price changes. Whether companies are having supply problems, workers aren't making enough money to pay the rent or fruit crops got caught in a deep freeze, it's all in there.

The survey's power to spook and spur markets lies in how the Federal Reserve Board interprets it and responds with changes in interest rates and monetary policy.

"The CPI is important because of the uses made of it," said Patrick Jackman, economist at the Bureau of Labor Statistics, which compiles the report. "It's the vehicle that is used to adjust Social Security payments, to adjust income tax brackets and exemptions, and a number of other things like labor contracts."

What's in the CPI

The CPI represents what's known as a "market basket" of goods and services by sending approximately 400 people nationwide on a scientific shopping and house-visiting trip recording month-to-month changes in prices. This basket includes items in eight basic categories: food, housing, clothing, transportation, recreation, education, and medical and personal care.

To measure inflation, the current standard reference time frame is from 1982-1984, and the base number is 100. The CPI for a given month is released two weeks after the end of that month.

While there are smaller CPI breakdowns of specific subsets, the overall CPI focuses on major trends in metropolitan areas. The CPI represents about 87 percent of the U.S. population, according to the BLS. Changes and buying habits among farmers and rural communities, military personnel, and institutionalized populations are not included in the results.

Investors take heed

"As an investor, you can't just be following the market."

John Ryding, Bear Stearns

Given the uncertainty of how the Federal Reserve will respond to the index, shareholders need to examine their choices since interest rates and the CPI move together.

"Higher interest rates are bad for business in general, and particularly for businesses that are highly leveraged -- that don't have much earnings compared to their growth. Some of our high tech right now would fall into that category," said Ginita Wall, executive director of San Diego-based Women's Institute for Financial Education. "So if you're seeing a prediction for higher CPI, if CPI is predicting higher interest rates, that probably says that people will be pulling back in the higher technology and growth stocks and perhaps going more for value or dividend-paying stocks."

"We're in a very jittery time," she said. "I think when you get into a jittery time, it's like being spooked in the middle of the night. Any noise will get you nervous, even if it's a noise that really could be predicted."

John Ryding, senior economist at Bear StearnsBSC, +2.22%
in New York, concurs that in the current market, Wall Street accentuates the negative when it comes to CPI. Prior to Tuesday's release of the July numbers, Ryding pointed out that "there have been six CPI numbers so far this year. One came in worse than expected, five came in better than expected, and the net result is the core CPI over the first six months of the year is the lowest since 1965. Now, it was the worse-than-expected number that grabbed the market's attention and still has it, to some extent."

Wall advises investors to take a circumspect attitude toward the CPI. "We've seen the market have severe problems in the last couple of weeks just thinking about this number that's going to be coming out and what it might do," she said. "So sometimes there's a relief rally. When the number comes out and it's no worse than people expected, the markets may actually go up instead of down, even if it's higher."

"The best thing for an investor to do is to take a long-term approach," says Wall. "If the CPI is higher, interest rates do go higher, stocks and bonds do go lower, that's a buying opportunity as opposed to a time to sell."

Ryding agrees. "As an investor you can't just be following the market," he said. "You've got to be investing on your view of fundamentals, and my view of fundamentals is that there is no inflationary pressures... It would take more than one bad CPI report to persuade me otherwise."

CPI past and future

The first Consumer Price Index was released in 1919, born out of a fear of strikes in the years during the first World War, according to Jackman. At that time, labor unrest in the shipbuilding industry in particular forced managers to take action. They pressed for a reliable government scale of how prices were moving so they could compensate workers for their loss of purchasing power, he said.

Today, one of the most common misconceptions about the index is that it should have a direct correlation with individual buying habits. The sample is just too expansive to expect such a close relationship, said Jackman. "Probably most of the inquiries by consumers, given the relatively low level of inflation that one currently has, is due to the fact that the benefit checks of Social Security recipients are lower than they used to be because those are tied directly to the CPI," he said.

"Their comments are often that the CPI doesn't reflect their expenditure pattern." For instance, they could be spending more money on prescription drugs, whose prices may be rising faster than other components of the index. "Their personal price index may be going up more rapidly, and the CPI doesn't reflect that."

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